Don't Underestimate EU Resolve

The second phase of the Greek bailout plan looked shaky as projections for the country’s debt under the plan were clearly unsustainable. A slight wobble to economic growth or lack of implementation would mean a third bailout or default.

Italy, with its downgraded GDP growth prospects,and Spain, with probable significant undisclosed debt amongst regional governments, could also end up with unsustainable debt. Fears of contagion are reverberating through the markets; even German and UK banks are being hammered.

Market murmurings concerning ECB solvency are growing as the bank has a massive portfolio of Greek and Portuguese bonds, and there is lack of intervention in the bond markets as yields have blown out.

A lot is riding on the EU meeting on Thursday, as a number of parties around Europe work long hours to thrash out a new deal.

The prospect of doing so looks daunting, but don’t underestimate European resolve to prevent a Greek default. The politicians know that a Greek default actually means a euro default instigated by the EU leaderhsip (or lack of it).

Little information seems to exist regarding what the EU is planning for Thursday. This silence is making the market nervious, some are taking it as a sign that there is no agreement and we are one step closer to default. Yet, from the scraps of information being reported, support is gathering for a scheme centered around bond buybacks. Perhaps this also helps explain the lack of ECB intervention: As secondary market yields explode, the idea of bond buybacks becomes more appealing.

If the EFSF buys the bonds directly, politicians are concerned that the EU is on a path to eurobonds, common fiscal policy and a further loss of national identity amongst the European nations. Therefore, the EFSF might lend to Greece directly or perhaps an intermediate "implementation" vehicle (let's call this the EU Monetary Fund) that has executive powers to administer the funds in the interest of the country in question, with EU oversight, including the ability to purchase the country’s bonds in the secondary market.

Such an EU fund administrator could help to alleviate concerns amongst politicians for the moral hazard risk of the bailed out country deciding to not meet its bailout conditions, reinforce any bailout arrangements by ensuring disbursements were closely linked to the technical teams monitoring and “assisting” countries to meet their austerity, tax collecting and privatization plans, and importantly act as the SPV proposed in the “French bank bailout” scheme.

Chancellor Merkel is sticking to her political ideology: Taxpayers can’t take all the burden and the private sector must be involved in the second bailout, but on a voluntary basis. This implies she has accepted the ECB’s view of “no default, selective default or credit event." Her finance minister is reportedly in favor of bond buybacks. Even the opposition party is calling on Merkel to be more pro-European since the crisis endangers the entire system. The IMF has also supported the idea of bond buybacks.

Ireland and Portugal naturally are asking for better terms in their bailout packages; the moral hazard problem of the Greek bailout is not simply that Greece might renege on its deal but the other bailout recipients might do so on the grounds of unfair treatments. A deal therefore must resolve all these issues if the EU crisis is to be kicked down the road for a significant amount of time, hopefully forever.

Given the state of play above, the answer looks likely to be along the following lines: The EFSF, recently expanded, lends money to bailout governments or even to a newly styled EU-Monetary Fund, or is sanctioned itself to initiate bond buybacks, including from the ECB. That makes a significant and quick improvement in debt sustainability.

Private sector involvement would be via the the EU-Monetary Fund, direct to Greece, in the form of a new round of loans at coupon rates higher than the original Greek debt but below secondary market rates and at extended maturities. With a bond buyer active in the secondary market, there will be some degree of equalisation between the new rates and existing yields. But it seems unlikely that such a rate would equalise to the point where new loans to Greece have the same rates as secondary market rates on existing loans.

Why would banks have an incentive to provide new loans at a discount from current (or likely) market rates when they know the money is for Greece, while voluntarily allowing the existing loans to be bought back, effectively taking a haircut via the secondary market? They might conjecture that given EU resolve to avoid a default, the EU would eventually pay up at time of maturity.

Additionally, the decision to sell those new bonds while retiring old Greek loans via the bond buy back has to be voluntary, in order to avoid rating agency action. The answer could lie in the savings made on the CDS spreads between the new EFSF/EU Monetary Fund bonds they buy and the amounts being paid on the current “at risk of default” Greek bonds.

And there is discussion of a bank tax aimed at collecting funds from the private sector, which would contribute to the EFSF. Such a tax could morph into a form of state insurance, effectively providing EU backed CDS on any new loans made.

While a bank takes a haircut on the old Greek bonds via the buyback, it would offset this against the lower cost of insuring against default it is paying on the EFSF debt. Indeed, the pricing of combined CDS/EFSF loan made to Greece, and CDS/ old Greek loans could be made in such a way as to create a clear incentive (slight positive profit) for the private sector to sell back existing Greek loans while lending new money to the EFSF/EU Monetary Fund. And such an incentive would create a line of banks willing to sell back – entirely voluntarily- the old Greek bonds, thereby avoiding credit event/selective default.

While the details of the likely outcome, centering as it does around bond buybacks, may vary from the above, the important thing to have is the EU political will to put more money on the table. All EU leaders have that. The ideal result from Thursday's meeting could well be an EU plan that ultimately involves:

Greece (and possibly Ireland and Portugal) with debt that is likely to be more sustainable, at lower interest rates and longer maturities.

Banks, including the ECB, have higher quality loans on their balance sheets.

The proposed new bonds issued are not default or junk status, so they can be accepted as collateral in ECB funding arrangements.

As the whole "rollover” of debt has effectively occured via the market mechanism of old bond buybacks and new bond auctions with voluntarily participants on either side (the tax element is not voluntary), the ratings agencies are not going to declare a default nor will it trigger a credit event. The EU will be left with the problem of ensuring the new loans don’t create a new moral hazard problem as countries seek to ignore spending or deficit limits and breach their bailout agreements.

But that was the original problem that led to the Greek and EU crisis in the first place: A lack of countries’ commitment to keep the monetary union in place. The solution to that problem lies in Brussels, and in the words of Trichet, is a problem for “the day after tomorrow” but not this Thursday.

For now, EU countries can preserve their national indentities, and pursue independent domestic fiscal policy. They now know full well the consequences of unilaterally threatening another “Greek crisis” if abandoning fiscal prudence – management teams from Europe and the IMF running the government; taxpayers with reduced wages rioting on the streets and, crippling debt servicing costs.

Ultimately, an EU commitment to “no default” that is binding on each country of the customs union, ensures precisely that all member states benefit from lower debt costs. The apparent lack of resolve amongst the EU to ensure “no default” is what is being priced into the Eurobond markets, but the self evident benefits of that resolve, and not just the costs of a Greek default, will ultimately ensure that the EU pulls a deal together.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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